What Are the Dangers of a Home Equity Line of Credit Loan?

by David Ingram

Home equity lines of credit use home values as collateral.

A home equity line of credit is a long-term credit arrangement that uses home value as collateral. Home equity lines of credit generally offer large amounts of credit at low monthly payments over a long period, called the draw period. These credit arrangements offer distinct advantages and disadvantages, and investors should become familiar with the dangers of a home equity line of credit before taking advantage of these unique loans.

Interest Rate Risk

Home equity lines of credit feature variable interest rates that move up and down in tandem with the prime rate--the rate at which banks lend money to each other and their most creditworthy borrowers. Variable rates are generally expressed as the prime rate plus a set amount of percentage points. The danger of variable interest rates is the possibility that rates will rise in the future. Consider, for example, if you were to take out a home equity line of credit at a variable rate, initially set at 7%, when fixed rate consumer credit arrangements are currently offered at 8%. If the variable rate increases to, say, 11% in four years, you could find yourself paying significantly more in interest than if you had taken the fixed rate loan.

Ease of Spending

Home equity lines of credit are easy to use, though they may not be easy to obtain. Since monthly payments are low and credit levels are high, consumers can quickly find themselves with buyers' remorse and a large amount of debt. As with credit cards, it can be easy to get out of control while justifying current purchases with future income expectations, which may not always turn out as planned.

Repayment

Although monthly payments are relatively low and payment term lengths are generally long, home equity lines of credit must be paid in full at the end of the draw period. This may not be a problem for borrowers who have made consistent monthly payments, but it can present a significant challenge to individuals on a temporarily tight budget. The danger inherent in the immediate repayment terms of home equity lines of credit is the risk that you may not be able to pay when the draw period ends, forcing you to obtain a loan from a secondary source.

Default Risks

More serious dangers are present if you cannot obtain a secondary loan to pay off your home equity line of credit balance at the end of the draw period. Aside from your taking a hit to your credit score and potentially seeking bankruptcy, the bank may choose to foreclose on your home, leaving you looking for a new place to live.

About the Author

David Ingram has written for multiple publications since 2009, including "The Houston Chronicle" and online at Business.com. As a small-business owner, Ingram regularly confronts modern issues in management, marketing, finance and business law. He has earned a Bachelor of Arts in management from Walsh University.

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